In the world of investment management there is an idea that blind-folded monkeys throwing darts at pages of stock listings can select portfolios that will do just as well, if not better, than both the market and the average portfolio constructed by professional money managers. If this is true, why might it be the case?
The Dart Board
Exhibit 1 shows the components of the Russell 3000 Index (regarded as a good proxy for the US stock market, the largest in the world) as of December 31, 2016. Each stock in the index is represented by a box, and the size of each box represents the stock’s market capitalisation (share price multiplied by shares outstanding) or “market cap” in the index. For example, Apple (AAPL) is the largest box since it has the largest market cap in the index. The boxes get smaller as you move from the top to the bottom of the exhibit, from larger stocks to smaller stocks. The boxes are also color coded based on their market cap and whether they are value or growth stocks. Value stocks have lower relative prices (as measured by, for instance the price-to-book ratio) and growth stocks tend to have higher relative prices. In the exhibit, blue represents large cap value stocks (LV), green is large cap growth stocks (LG), grey is small cap value stocks (SV), and yellow is small cap growth stocks (SG).
. The ratio of a firm’s market value to its book value, where market value is computed as price times shares outstanding and book value is the value of stockholder’s equity as reported on a company’s balance sheet.
Exhibit 1. US Stocks Sized by Market Capitalisation
For illustrative purposes only. Illustration includes constituents of the Russell 3000 Index as of December 31, 2016, on a market-cap weighted basis segmented into Large Value, Large Growth, Small Value, and Small Growth. Source: Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Please see Appendix for additional information.
SO… THROW AWAY?
This does not mean, however, that haphazardly selecting stocks by the toss of a dart is an efficient or reliable way to invest. For one thing, it ignores the complexities that arise in competitive markets.
Consider as an example something seemingly as straightforward as a strategy that holds every in the Russell 3000 Index at an equal weight (the equivalent of buying the whole dart board in Exhibit 2). In order to maintain an equal weight in all 3,000 securities, an investor would have to re-balance frequency, buying shares of companies that have gone down in price and selling shares that have gone up. This is because as prices change, so will each individual holding’s respective weight in the portfolio. By not considering whether or not these frequent trades add value over and above the costs they generate, investors are opening themselves up to a potentially less than desirable outcome.
Instead, if there are well-known relationships that explain differences in expected returns across stocks, using a systematic and purposeful approach that takes into consideration real-world constraints is more likely to increase your chances for investment success. Considerations for such an approach include things like: understanding the drivers of returns and how to best design a portfolio to capture them, what a sufficient level of diversification is, how to appropriately re-balance and how to manage the costs associated with pursuing such a strategy.
THE LONG GAME
Finally, the importance of having an asset allocation well suited for you objectives and risk tolerance, as well as being able to remain focused on the long term, cannot be overemphasised. Even well-constructed portfolios pursuing higher expected returns will have periods of disappointing results. A financial adviser can help an investor decide on an appropriate asset allocation, stay the course during periods of disappointing results, and carefully weigh the considerations mentioned above to help investors decide if a given investment strategy is the right one for them. This what our staff at Callisto Wealth do best! If you wish to start planning for your retirement and get the most of your money,click here.
So what insights can investors glean from this analysis? First, by titling a portfolio towards sources of higher expected returns, investors can potentially outperform the market without needing to outguess market prices. Second, implementation and patience are paramount. If one is going to pursue higher expected returns, it is important to do so in a cost-effective manner and to stay focused on the long term.
Large cap is defined as the top 90% of market cap (small cap is the bottom 10%), while value is defined as the 50% of market cap of the lowest relative price stocks (growth is the 50% of market cap of the highest relative price stocks). For educational and informational purposes only and does not constitute a recommendation of any security. The determinations of Large Value, Large Growth, Small Value, and Small Growth do not represent any determinations Dimensional Fund Advisers may make in assessing any of the securities shown.